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Fixed-Income Insights

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Are Convertibles the Right Vehicle for the Road Ahead?

The twin prospects of normalization in interest rates and more typical returns for equities in 2014 may lend appeal to convertible bonds.

In Brief

Convertible bonds, which share characteristics of both equity and fixed-income securities, may provide relatively attractive income, while enabling participation in rising equity markets.

Better economic growth could enhance corporate earnings and promote attractive equity returns. Bonds that are convertible into equities tend to participate in that equity movement.

Convertible bonds tend to be negatively correlated with U.S. government bonds. That could lend additional appeal to the asset class amid concerns about a continued rise in interest rates.

The key takeaway: Convertible bonds may be part of an investment strategy that can help investors transition to a period during which interest rates normalize and equity performance returns to closer-to-average levels.

Investors may think they face a dilemma as the calendar has flipped into 2014. Should they be distraught with the prospect of another year of negative returns in high-quality fixed-income categories? Should they worry that after a 32% rally in the S&P 500® Index in 2013 (based on Bloomberg data), the current valuation on the equity market presents a poor entry point for new exposure?

Their conundrum may be more imagined than real. The improvement in U.S. economic growth that prompted the Federal Reserve to taper its monthly bond purchases, along with the related losses in high-quality fixed-income categories, will likely support both lower-quality bonds and equities in 2014.

That said, where, then, can investors who are seeking a tidy solution that addresses income, equity participation, and a degree of protection from equity market losses find a timely opportunity in the New Year? Convertible securities may be the answer.

Hybrid Vehicles
Convertibles, although often overlooked, may provide relatively attractive income, while enabling participation in rising equity markets. And historically they have provided some downside protection during periods of declining stock prices. [There is no guarantee that they will continue to do so in the future.] Should investors decide to finally deploy the significant cash reserves they hold as 2014 dawns, convertibles may offer them a vehicle that will allow them to increase equity exposure, yet retain some desirable characteristics of bonds.

Investor concerns about higher interest rates and lower bond prices are legitimate, at least with regard to long-term Treasury securities. The Fed's return to a less aggressively accommodative monetary policy seems certain to push interest rates higher on those securities that it will no longer purchase, namely agency mortgage-backed securities and longer-dated Treasuries. In 2013, the anticipation of tapering pushed longer-term U.S. Treasury yields higher and, subsequently, produced negative returns among traditional high-quality bond havens. The gradual unwinding of the Fed's $85 billion monthly bond purchase program begins a multiyear process of interest rate normalization, whereby overnight rates, according to the Fed, will return to 4% from their current level of near 0%, and other rates will fall into line.

While bonds of lower-quality and shorter maturities could provide some protection from interest rate risk throughout this process, long-term, high-quality bonds appear to be at risk to provide low, if not negative returns.

Kicking the Tires
While lower-quality bonds, because of their economic sensitivity, should perform relatively well as the Fed tapers, convertibles offer perhaps an even more interesting alternative for 2014. If Fed tapering is dependent on better economic growth, that growth could enhance corporate earnings and promote respectable equity returns. Bonds that are convertible into equities tend to participate in that equity movement, depending upon the proximity of the price of the underlying stock to the strike price of the convertible. For example, during 2013, convertibles (as represented by the BofA Merrill Lynch All Convertibles, All Qualities Index) returned 27%, compared to a 32% gain for the large cap S&P 500 and a 37% return for the small and mid cap benchmark Russell 2500 Index, or about 82% and 72%, of equity index returns, respectively. (All performance data are from Bloomberg.)

At the same time, convertible bonds tend to be negatively correlated with U.S. government bonds. This relationship was vividly portrayed in 2013 as the Barclays U.S. Government Bond Index fell 2.6%, according to data from Barclays, while the BofA Merrill Lynch All Convertibles, All Qualities Index enjoyed a 27% gain, according to Bloomberg. Chart 1 shows that 2013 was not an anomaly, at least not in terms of direction of performance. Over the past decade, convertible bonds have had a correlation of -0.26 with the Barclays U.S. Government Bond Index, while the Barclays U.S. Aggregate Bond Index, considered a proxy for the traditional "core" strategy of high-quality government and corporate bonds, had a correlation of +0.88 with the same government bond index.

Chart 1. Convertibles Historically Have Had a Low Correlation with Government Debt

Correlation with Barclays U.S. Government Bond Index, November 1, 2003-November 30, 2013

Correlation is a statistic that measures the degree of association between two variables.

Past performance is no guarantee of future results.
For illustrative purposes only and does not reflect any Lord Abbett mutual fund or any particular investment. Indexes are unmanaged, do not reflect the deduction of fees or expenses, and are not available for direct investment.

Over the past 20 years, convertible bonds have generally provided positive performance during periods of rising interest rates. Chart 2 illustrates convertible bond performance in periods when the 10-year U.S. Treasury note rose at least 100 basis points (bps) in yield. A negative correlation to government securities and a strong relationship with equities could be an attractive investment feature, depending on investors' expectations for the next few years.

Chart 2. Convertibles Historically Have Held Their Own During Periods of Rising Interest Rates

Index returns during the last seven periods of greater than 100-basis-point increases in the 10-year Treasury yield (month-end data)

Past performance is no guarantee of future results.
For illustrative purposes only and does not reflect any Lord Abbett mutual fund or any particular investment. Indexes are unmanaged, do not reflect the deduction of fees or expenses, and are not available for direct investment.

The Right Model for 2014?
All well and good, you may say, but how have convertibles performed when the equity market hits a rough road? Surely, there must be a cost to an investment that can provide such an intriguing combination of fixed-income and equity characteristics. Indeed, the economic sensitivity of convertible bonds cuts both ways. As equity prices decline, so will those of related convertible issues—but not as significantly as one may think. At some point, the bond characteristics of the convertible kick in—that is, the price stops falling when the convertible becomes attractive as a pure bond. At this point, if the underlying stock continues to fall, the convertible maintains its value as a bond. Indeed, the traditional return profile of convertible securities indicates that while they might capture approximately 70% of an upswing in the underlying equities, they might participate in only about 40% of a decline in the underlying equities.

Although convertibles may not perform in a similar manner in the future, this could mean that investors who would like to increase equity holdings, but are fearful of a market decline, might consider convertible bonds as a less volatile strategy to gain equity exposure. Other equity investors looking to protect their downside risk, yet fearful of missing out on additional upside moves in the market, also may select convertible bonds as a less volatile substitute for current equity holdings. Such investors may be willing to capture less than 100% of a stock's upside in exchange for the historical downside protection that convertibles have historically provided.

Given the twin dilemmas that many investors face—a need for income, but a fear of rising rates, and a desire for equity exposure, but a fear of falling prices—convertible bonds may be part of an investment strategy that helps investors transition to a period where interest rates gradually normalize at a higher level and equity returns adjust to more typical levels.

Risks to Consider:
The value of investments in equity securities will fluctuate in response to general economic conditions and to changes in the prospects of particular companies and/or sectors in the economy. The value of investments in fixed-income securities will change as interest rates fluctuate. As interest rates fall, the prices of debt securities tend to rise, and as interest rates rise, the prices of debt securities tend to fall. Bonds may also be subject to other types of risk, such as call, credit, liquidity, interest-rate, and general market risks. Convertible securities have both equity and fixed-income risk characteristics. Like all fixed-income securities, the value of convertible securities is susceptible to the risk of market losses attributable to changes in interest rates. Generally, the market value of convertible securities tends to decline as interest rates increase and, conversely, to increase as interest rates decline. Mortgage-backed securities are subject to pre-payment risk. Longer-term debt securities are usually more sensitive to interest rate changes, the longer the maturity of a security, the greater the effect a change in interest rates is likely to have on its price. Lower-rated investments may be subject to greater price volatility than higher-rated investments.

No investing strategy can overcome all market volatility or guarantee future results.

Treasuries are debt securities issued by the U.S. government and secured by its full faith and credit. Income from Treasury securities is exempt from state and local taxes.

The Barclays U.S. Aggregate Bond Index is an unmanaged index composed of securities from the Barclays Government/Corporate Bond Index, Mortgage-Backed Securities Index and the Asset-Backed Securities Index. Total return comprises price appreciation/depreciation and income as a percentage of the original investment. Indexes are rebalanced monthly by market capitalization.

The Barclays U.S. Government Bond Index is a market value-weighted index composed of all publicly issued, nonconvertible, domestic debt of the U.S. government or any agency thereof, quasi-federal corporations, or corporate debt guaranteed by the U.S. government. Flower bonds and pass-through issues are excluded. Total return consists of price appreciation/depreciation plus income as a percentage of the original investment. Indexes are rebalanced monthly by market capitalization.

The BofA Merrill Lynch All Convertibles, All Qualities Index contains issues that have a greater than $50 million aggregate market value. The issues are U.S. dollar-denominated, sold into the U.S. market, and publicly traded in the United States.

The Citigroup 10 Year Treasury Bond Index is a broad measure of the performance of the medium-term U.S. Treasury securities.

The S&P 500® Index is widely regarded as the standard for measuring large cap U.S. stock market performance and includes a representative sample of leading companies in leading industries.

The Russell 2500™ Index is a market cap-weighted index that includes the smallest 2,500 companies covered in the Russell 3000 universe of United States-based listed equities.

A basis point is one hundredth of a percentage point, and 100 basis points equals 1%.

Strike price refers to the price at which a specific derivative contract can be exercised. For convertible securities, this refers to the agreed-upon price at which a bond holder may convert his or her creditor position to that of an equity holder.

Upside capture/downside capture ratio: Upside capture ratios for funds are calculated by taking a fund's monthly return during months when the benchmark had a positive return and dividing it by the benchmark return during that same month. Downside capture ratios are calculated by taking a fund's monthly return during the periods of negative benchmark performance and dividing it by the benchmark return.

Indexes are unmanaged, do not reflect the deduction of fees or expenses, and are not available for direct investment.

ABOUT THE AUTHOR

The opinions in the preceding commentary are as of the date of publication and subject to change based on subsequent developments and may not reflect the views of the firm as a whole. This material is not intended to be legal or tax advice and is not to be relied upon as a forecast, or research or investment advice regarding a particular investment or the markets in general, nor is it intended to predict or depict performance of any investment. Investors should not assume that investments in the securities and/or sectors described were or will be profitable. This document is prepared based on information Lord Abbett deems reliable; however, Lord Abbett does not warrant the accuracy or completeness of the information. Investors should consult with a financial advisor prior to making an investment decision.

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